Should You Save Money or Pay Off Debt?

After a few years of being down, many of us are finding ways to get our finances back in order. While some extra money in your pocket is great, understanding what to do with it is a different story. Our friends, family members and of course random personal finance bloggers are telling you that you need to save more money, but is it smarter to save money or pay off debt with it?

The Argument for Saving Money

Saving money not only makes our bank statement look pretty and not only helps us to make big expensive purchases like a house or car, or pay for your child’s education down the line, but it also provides us with a certain amount of security in situations that may require a lot of money like the loss of a job or large unexpected medical bills.

How much money you should have saved is a matter of personal preference, but the way I try to figure out how much money I should have saved is to add up all my expenses for an average month and multiply it by the number of months it would potentially take me to find a new job. That way I know that should I lose my primary source of income, all of my expenses would be covered.

The Argument for Paying Off Debt

As a result of the bad economy or just poor budgeting habits, almost all of us have too much debt on the books. Whether it’s credit cards, mortgages, car loans, student loans or any other kind of debt, we have too much of it and I know I don’t have to tell many of you that it weighs on your budgets and your emotions. So if you find yourself having some extra money would you be better off paying off debt than just sticking it in a bank account somewhere?

One of the main reasons why people like to pay off debt first is that credit card interest rates (or rates charged for holding other forms of debt) are usually much higher than you could with a savings account. Even ING Direct, who has one of the nation’s highest savings account interest rates, is only yielding 1.10% at the time of this writing. If you’re sitting on credit card debt of 19.99% or higher obviously you would be losing money here.

One of my favorite benefits of paying off debt (aside from the relief you feel from not having it) is the free cash flow that it creates. Many of you have heard of Dave Ramsey’s debt snowball, which essentially says pay off the debt you can get rid of fastest and then use that money to pay off other debt and so on.

The more cash you free up each month the more leverage you have to pay off other debts. Well once you get everything paid off you can use that cash for fun things too. Looking back I used to pay anywhere between $200 and $1,000 or more every single month paying off my credit cards, so once they were paid off for good I had a lot of extra money to invest, put in to my son’s 529 account or just to take my wife out to a nice dinner with.

Saving Money vs Paying Off Debt

So what should you do with your extra money? Well there is no one right answer for everyone as we are all in different boats, but here’s what I would do if it were up to me… First I would put away at least a couple month’s expenses in the savings account. These days nobody’s job is truly safe and you need to have at least some cushion to pay your bills if you don’t have a job. Once you have that cushion built up to a comfortable level then you need to start paying off that debt as fast as possible.

The truth is whether you save money or you pay off debt with it, you won’t go wrong with either option so do what makes you feel comfortable in your own personal finances and you will be much happier as a result.